Quality Counts in Late Bull Markets

According to Warren Buffett, "You only find out who is swimming naked when the tide goes out." That means that quality is more important than ever near the end of major bull markets. The highest quality investments are precisely the ones that have done the best when the market is at its worst.

Bond investors have already forgotten what happened during the Financial Crisis in 2008. Junk bonds fell a catastrophic 24% in just one year, and even investment-grade bonds had negative total returns. These stunning losses include the interest payments, so the price declines were even steeper. As the extent of the disaster became apparent, bond investors around the world flocked to the relative security of US government bonds. US treasuries went up in 2008 as the rest of the bond market was falling apart. Quality was the key.

The damage to the stock market in 2008 was much more extensive. The S&P 500 lost 37%, but there are always some stocks that outperform. Many of the best investors prefer stocks that have grown their dividends year after year. While any stock can offer temporarily high dividends to lure in the unwary, consistent growth in dividends is a sign of competent management dedicated to improving shareholder value. The higher quality dividend growth stocks lost "only" 26% in 2008. That shows us that quality counts, but it also shows the limits of diversification within the stock market.

Some investors think that gold is just another commodity, but the facts tell a different story. During the last major stock market crash in 2008, overall commodity prices fell 42% and underperformed even the S&P 500. Gold is the highest quality commodity, and we've learned by now that quality makes a difference in bear markets. Gold actually went up 4% in 2008, 26% in 2002, and 66% in 1974 according to the World Gold Council. As bear markets proceed and more paper promises are broken, the value of gold keeps increasing. The fact that gold hasn't had a year like 1974 in decades suggests that the secular bear market is not over and the worst is yet to come.

The bull market in stocks is so long in the tooth that even its FAANGs (Facebook, Apple, Amazon, Netflix, Google) started falling out when the price of Facebook dropped dramatically in late July. There is very little time left to shift your portfolio to higher quality investments like gold. All the economic analysis in the world cannot help you if you do not act. As Warren Buffett said, “Predicting rain doesn’t count. Building arks does.”

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